In a basket CDS ,the reference portfolio has 16 assets with varying credit grades of USD 0.5million each. The portfolio holder wants to buy protection by way of basket CDS only on 5subordinate credit exposures and leave the senior credit exposure uncovered. To arrive at the CDSpremium, you are studying the correlation relationship of the 16 exposures. Which one of thefollowing statements is respect of quoting CDS premium for 5 subordinate credit exposures iscorrect.Select one:a. The premium will be more if the names in the portfolio are highly correlated .b. The premium will be less if the names in the portfolio are highly correlated .c. Correlation is not a relevant input in quoting premium and could be ignored.d. The premium will be less if the names in the portfolio are negative correlated

The correct answer is B.The subordinate grade in the reference basket is more likely to default than the seniorgrades. Theprobability of default of the subordinate grade is reduced if it is more correlated with the seniorgrades. Hence the premium payable will be less . All other statements, except B, are contrarystatement.

Hi,Option (B) says that the premium will be less if the names of the portfolio are highly correlated.

We know that subordinate credit exposures are always relatively riskier and hence more likely to default than the senior credit exposures.

Now if all the names in the CDS basket are correlated, it means the subordinate grades are correlated with the senior grades. Now since the senior grades have a very low probability of default, correspondingly the junior or subordinate grades will have a lower PD too (This because of correlation amongst all the grades in the CDS).

Since the PD will be less, the CDS premium payable will also be lesser.

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